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The Externality Debate: Remember Subjectivity in Economic Science

“Greenhouses set up next to carbon-dioxide emitting factories give food producers easy access to the gas their plants love…. Everyone on the planet eats food, so perhaps a tax should be imposed on every global citizen to remunerate the creators of carbon dioxide.”

I doubt this suggestion will find much support; I don’t even believe in it! But the reason that I don’t believe in it has nothing to do with my feelings over the goodness or badness of the externalities in question. Instead it stems from a recognition that we just don’t know what the relevant externalities are.

One of the greatest contributions of the Marginal Revolution from 1871-74 was a focus on subjectivity as the fount of value. From thence forth no economist could say that value was inherent in a good or the result of its costs of production, as had been the case for thousands of years.

Now, value was properly reckoned as the personal and wholly subjective assessment by an individual of the usefulness that a good would serve in fulfilling a need specific to him.

Yet despite the persuasiveness of the arguments put forth over the last 140 years, there are still fields within economics where an objective conception of value is used. Nowhere is this error more apparent than in the common treatment of externalities.

Externality Analysis

An externality is the result of one person’s activity affecting an innocent bystander. The externality is positive in that it creates value for the innocent bystander, and negative if a cost is imposed on him.

In general, economists argue that markets allocate goods well when costs and benefits are internalized. When you get the benefits from buying a good or pay for the costs of producing it an efficient level of consumption and production will occur.

Externalities are problematic, supposedly, as they remove the possibility that the person benefiting from the good will solely be the person paying for it. Alternatively, there could be a problem where the person producing something will not be required to pay for all the costs if some costs are imposed on others via a negative externality. All this is subsumed under the term, “market failure.”

Economists are very quick not to pass value judgments on peoples’ choices for the simple reason that even though they may look faulty to us, we are not in a position to know the actual tradeoffs, options or knowledge available to the individual making the choice.

Lower cigarette prices make a smoker better off from an economic viewpoint because we are unsure of what the smoker’s criteria are for his action although we probably all agree that the activity is not a wise health choice. If the smoker is pursuing his habit, it is only because he perceives the benefits to outweigh the costs, at least as he perceives them. (And reducing the costs through lower cigarette prices must, therefore, make him better off.)

Externalities are a little bit of a paradox in light of this. Externalities are commonly categorized as negative or positive depending on whether the economist perceives them to be helpful or harmful. Education is commonly cited as being positive, as an educated population gives beneficial side effects to third parties in the economy – more job opportunities are created through their ideas, for example. Smoky factories are a negative externality because they impose a cost on others through the health damage caused by their pollution.

Maybe the examples are not as clear cut as may be supposed. Perhaps that smoky factory brings harm through pollution, but does well through job creation. Of course, if you work in one of those jobs you are compensated for the benefit through your wage, but even innocent third parties might benefit. I think many (though admittedly not all) people would prefer to live in a town with employment opportunities than no future. The bad the factory does to the town through smoke is perhaps offset by the good provided by a brighter future for its inhabitants.

The key in the preceding example is admitting that we just don’t know what the extent of the externalities are. Some people unconcerned with pollution may welcome the job creation. Those with jobs might not care about that benefit, and instead focus on the negative nature of the pollution. The fact is that at the end of the day we are not in a position to pass a judgment on one or the other. We just don’t know what the relevant externality is, or even whether it is positive or negative.

Climate Change Debate

This is not just armchair theorizing without real world implications. The problem creeps up continually.

In the global warming debate, for example, the phrase “climate problem” assumes clear, net negative externalities. Anthropogenic (man-made) global warming will raise sea temperatures and flood low-lying areas. The people who live in these low-lying areas didn’t do anything to cause the climate to change, but they will bear the costs of having their livelihoods removed.

One man from the low-lying South Pacific island of Kiribati just sought asylum in New Zealand to escape this painful future. In fact, there were reports of the entire nation of Kiribati negotiating to buy land in New Zealand so as to keep their nation alive even when the sea floods its islands. Should we really expect this small country to pay for its relocation when it had almost no part in the increase in sea levels?

The commonly accepted doctrine of externalities would answer that question in the negative. There is a negative externality imposed on the residents of Kiribati which should be rectified by having the person who caused the externality pay. This commonly means the citizens of developed countries who are at least by some measures the creators of climate change wreaking havoc with the world’s sea level.

Positive Externalities Too …

Yet evidence for positive externalities from climate change also exists. This report (pdf here) argues that increased levels of carbon dioxide emissions are creating a positive effect on agricultural output.

This should not be surprising, but here’s something that probably will be. The world’s second largest agricultural exporter after the United States is the tiny nation of the Netherlands. This doesn’t come by accident. The Dutch work hard to get every ounce of product out of the land that God gave them and that they created themselves. Greenhouses set up next to carbon dioxide emitting factories give food producers easy access to the gas their plants love – farmers pump this gas into the greenhouses to spur on plant growth and output.

Yet what the Dutch farmers would have to pay is what the world is getting for free from carbon dioxide emissions. Maybe instead of being a negative externality there is actually a positive aspect to these emissions, and as per standard microeconomic theory those who benefit should pay those who create the positive externality. Everyone on the planet eats food, so perhaps a tax should be imposed on every global citizen to remunerate the creators of carbon dioxide.

I doubt this suggestion will find much support; I don’t even believe in it! But the reason that I don’t believe in it has nothing to do with my feelings over the goodness or badness of the externalities in question. Instead it stems from a recognition that we just don’t know what the relevant externalities are.

Conclusion

Economics was put on solid footing by a simple lesson in subjectivity learnt over 140 years ago. A simple refresher course would serve most people well, and remove the pretence of knowledge that some people have regarding the actions of others and their and side effects.

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David Howden is Chair of the Department of Business and Economics, and professor of economics at St. Louis University—Madrid. Professor Howden is also academic vice president of the Ludwig von Mises Institute of Canada, and winner of the Mises Institute’s Douglas E. French Prize.

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Related Posts at MasterResource

The Positive Social Benefits of Carbon Dioxide (October 24, 2013)

“The Greening of Planet Earth” (June 25, 2013)

55 Positive Externalities: Hail to Atmospheric CO2 Enrichment (March 10, 2011)

7 comments

1 Tom Tanton { 11.08.13 at 8:29 am }

All well said. In addition to the points made well here, there are additional aspects that more than confound valuing (or worse monetizing) externalities, be they of criteria pollutants, GHG or other vectors. First is the co-mingling of deterministic and probabalistic estimates, essentially mixing accounting with insurance/risk management. Second is the non-linear and moral code behind ‘values.’ For criteria pollutants values depend on place, time and of course receptor sensitivity. Do we accept a value based on the sensitivity of asthmatics or more general population?
Heizenberg would be proud.

2 Eddie Devere { 11.08.13 at 10:19 am }

I’m glad to see that there’s finally an author on this blog who realizes that human-induced emissions are (a) increasing the concentration of CO2 in the atmosphere, (b) increasing the temperature of the Arctic (faster than elsewhere because there’s virtually no water vapor in the Arctic to compete with CO2 as a GHG), (c) causing the land-based Arctic sea ice to melt, (d) causing the sea level to increase, and (e) causing economic damage to people who live near low-lying coastlines.

I agree with some of the general conclusions of this essay: when it’s difficult for free-markets to determine if there are negative or positive externalities, it’s just as difficult for governments to determine whether there are negative or positive externalities.

But the main problem I see with this post, as with the other posts on this website, is that the authors seem to ignore the major negative benefits of CO2 emissions, and to act as if positive externalities were a good thing. Both positive and negative externalities are bad.

One (non-governmental) way to address climate change externalities is through public shaming of climate change denialists and climate change alarmists.

Human societies find ways of solving problems even when governments don’t act. If climate change denialists (and those purposely obfuscate the facts) continue to push to keep the government from taxing CO2 emissions, then humans will continue to find ways of humiliating climate change denialists in public. (Political cartoons, op-eds, etc…)

Given that this is a free-market website that doesn’t want to see government involvement in markets, why haven’t the authors of this blog encouraged non-governmental ways to fix what is clearly a market fail (both positive and negative externalities associated with CO2 emissions)? Positive externalities don’t cancel out with negative externalities because they effect different people differently. As a free-market website, you all should be concerned with ways to eliminate both the positive and the negative externalities of CO2 emissions. (The fact that you all don’t seem to want to remove both the positive and negative externalities is a worrying sign that you all are not really free-market libertarians…and just fossil fuel enthusiasts masquerading as free-market libertarians.)

The only “solution” I’ve seen on this website is “Do Nothing” and “Humiliate Climate Change Alarmists.”

The authors could humiliate climate change denialists just as much as they humiliate climate change alarmists. (This would also help to show that they are not biased themselves.) This is one non-governmental to start to solve the problem. By humiliating climate change denial (as well as climate change alarmism), we can start to educate the public on the real problems (without using tax payer dollars.)

But just as there is market-failure and government failure, there’s also social failure. Sham campaigns might fail just as horribly as the current market and government attempts to remove the positive and negative externalities of human emissions of CO2. A true free-market libertarian should be open to all three options: (1) markets, (2) governments and (3) social conventions (shamming, tipping, etc…) as means of addressing positive and negative externalities. And they should not presume that one of these options is always the best.

3 rbradley { 11.08.13 at 12:28 pm }

Eddie:

You just assume that the science is settled toward CO2 horribles. It is not and moving the other way.

Social and governmental efforts to reduce oil, gas, and coal usage in the name of ‘stabilizing climate’ is a cure far worse than the disease.

A libertarian is interested in sound science and outcomes, not only market and social forces for change. There are real problems to solve in place of very speculative, very long distance ones.

If you are really a libertarian, why are you fixated on Big Government in the name of Climate Planning? And why do 99% of libertarians disagree with you? Do you have, as Hayek would say, a fatal conceit?

4 John Shepard { 11.09.13 at 9:35 pm }

“If global warming or ozone depletion or whatever, really are consequences of the actions of the human race considered collectively, but not of the actions of any given individual, including any given individual private business firm, then the proper way to regard them is as the equivalent of acts of nature. Not being caused by the actions of individual human beings, they are equivalent to actions not morally caused by human beings at all, that is to say, to acts of nature.

“Once we see matters in this light, it becomes clear what the appropriate response is to such environmental change, whether global warming and ozone depletion, or global cooling and ozone enrichment, or anything else nature may bring. It is the same as the appropriate response of man to nature in general. Namely, individual human beings must be free to deal with nature to their own maximum individual advantage, subject only to the limitation of not initiating the use of physical force against the person or property of other individual human beings. By following this principle, man will deal with the any negative forces of nature resulting as byproducts of his own activity taken in the aggregate in precisely the same successful way that he regularly deals with the primary forces of nature.”

Lengthy, but excellent article.

“Environmentalism Refuted” by Dr. George Reisman:

http://mises.org/daily/661/Environmentalism-Refuted

5 Frank { 11.10.13 at 5:18 am }

It seems to me that it is the job of scientists report as accurate a range of warming and other climate change associated with a future doubling of atmospheric CO2. I don’t think their current answer is very useful (70% chance of 1.5-4.5 degC) or unbiased, but it’s a place to start. The other climate changes and sea level rise are more difficult to project.

Isn’t it the job of economists to try to put a price on positive and negative externalities of CO2 – rather than have legislators make less educated guesses than benefit their cronies and special interests? An honest answer today might be: “We can’t tell because the uncertainty in projected warming is so large. However, if the answer were 2 degC, the range would be ?-? and if the answer were 3 degC, the range would be ?-?.” Like scientists, perhaps you can’t come up with an answer accurate enough and unbiased enough today to be of real use to policymakers, but I think the scientist’s answer will improve with time. (Climate models may be hopeless because they contain too many parameters whose correct values can’t be rigorously optimized to agree with observations of current climate, but energy balance models based on observations of forcing, surface temperature and ocean heat content are looking promising – especially if Nic Lewis’ approach to eliminating uniform priors and asymmetric pdfs can’t be refuted.) Professor Howden doesn’t want economists to try. Ceding the field to those economists who over-estimate their capabilities and are willing to try appears to be a tactical mistake. Exposing their over-confidence and biases might lead to a better outcome. Who knows what disruptive technologies will appear in the next few generations that will “change everything”?

6 Weekly Climate and Energy News Roundup | Watts Up With That? { 11.10.13 at 9:01 pm }
7 What happened to 5.36 giga-dollars in CA? | Jerry Graf - Energy Strategy { 12.15.13 at 1:07 pm }

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